Homepage
PR Newswire
26-09-2023, 09:49 AM
Imagine that you have $100 invested equally in 2 stocks ie $ 50 each.
Your total gain is the sum of $ 5 gain from A and a loss of $ 2.50 from B = $ 2.50 overall gain.
Now if you had invested the $ 100 in A alone, your gain would be $ 10. But if you had invested all in B alone, you would have lost $ 5.
This is the impact of diversification. It reduces the overall gain but it also reduces the overall loss
The more stocks you have given the same $ 100, the less potential gain. But then the risk of a loss is reduced.
Of course, you don't know how individual stocks will turn out so you try to have as many as possible so that if a few does badly the others will do well enough to more than offset the bad ones.
So, what is the optimum number of stocks. Studies have shown that the benefits of diversification become marginal after 30 uncorrelated stocks.
It has to do with the fact that the risk of a loss can be separated into systemic and non-systemic risks.
Non systemic risks are those specific to a company eg its product risks. Systemic risks are those the affect the whole economy eg depression.
If you have 30 uncorrelated stocks the theory is that you diversify away all the non-systemic risks. But you are still left with the systemic ones.
There are ways to reduce the systemic risks but it is not from having more diversified stocks.
Real life is not so simple.
- A had 10 % return
- B had a loss of 5 %
Your total gain is the sum of $ 5 gain from A and a loss of $ 2.50 from B = $ 2.50 overall gain.
Now if you had invested the $ 100 in A alone, your gain would be $ 10. But if you had invested all in B alone, you would have lost $ 5.
This is the impact of diversification. It reduces the overall gain but it also reduces the overall loss
The more stocks you have given the same $ 100, the less potential gain. But then the risk of a loss is reduced.
Of course, you don't know how individual stocks will turn out so you try to have as many as possible so that if a few does badly the others will do well enough to more than offset the bad ones.
So, what is the optimum number of stocks. Studies have shown that the benefits of diversification become marginal after 30 uncorrelated stocks.
It has to do with the fact that the risk of a loss can be separated into systemic and non-systemic risks.
Non systemic risks are those specific to a company eg its product risks. Systemic risks are those the affect the whole economy eg depression.
If you have 30 uncorrelated stocks the theory is that you diversify away all the non-systemic risks. But you are still left with the systemic ones.
There are ways to reduce the systemic risks but it is not from having more diversified stocks.
Real life is not so simple.
- If you are an idiot and invest blindly, no amount of diversification will help you.
- It is very hard to find uncorrelated stocks. There is always some correlation. Remember how all fell in Mac last year due to Covid-19?